Just when they look risky, equities may be coming close to a really good long-term entry point.
All of us have always been taught that equities are by far the best long-term investment one can own. They capture the growth and dynamism of the corporate sector and are the best way to participate in economic development. “Buy and hold” has been the prevalent mantra, and that was always seen as the best way to maximise long-term wealth creation. However, looking at data over the recent past one can be forgiven for being sceptical and questioning the logic of the “buy and hold” investment style.
The MSCI global equity index today (as of end-December 2008) is no higher than it was in early 1997, and in real terms (inflation-adjusted) it is astonishingly back to the levels of 1973. When one thinks about it, it is truly amazing that the global equity markets have shown no rise in real terms for over 35 years. The above numbers only look at returns for global equities without considering dividends (only capital appreciation assuming no dividends), and on that data equities have massively underperformed for decades. If we look at total returns — which includes dividends and capital appreciation (assuming that all dividends were reinvested) — then equities have done a little better, underperforming from the mid-1990s.
Looking at total equity returns in comparison with bonds and cash also throws up some disturbing results. Investors would have been better-off holding a diversified basket of global government bonds than equities since 1970 and even cash has done better then global equities since 1987. On a risk-adjusted basis, the results have been even worse, for global government bonds have been able to deliver superior absolute returns with far lower risk, not to speak of zero-risk cash outperforming equities.
These are obviously horrible results for anyone who believed in buying global equities for the long term and adopted a passive “buy and hold” strategy. One could have obviously done much better if you had been able to time the ups and downs in the markets, and entered and exited in time, or were able to buy the right countries and stocks, but most large long-term investors tend to adopt a more passive approach. This comparison data is for the MSCI global equity index, and one should not forget that the majority of active managers actually fail to consistently beat the relevant indices, and so chances are that any manager you had employed to manage a global pool of equity assets would have done even worse than the above data.
It is surprising that one has not seen more coverage and debate on the poor returns delivered by global equities over the last decade. Confidence in equities as the best place to park your long-term savings has got to have been shaken. Having just experienced two severe bear markets this decade alone, investors must be questioning their asset allocation towards equities. We run the risk that investors get disillusioned and use any strength in markets to lighten up on their equity exposures. Such behaviour, were it to come to pass, would set a ceiling on the equity markets for the short term at least, as any strength in the markets will be met by selling by investors looking to allocate out of equities.
A lot of the asset allocation policies adopted by many of the real money long-term investors must also be now under question. These policies are based on the framework that over the long term, equities always deliver the highest absolute returns. Most such strong hands, be they foundations, family offices or sovereign wealth funds, must now be questioning their long-term equity allocation. Most have upwards of 50 per cent in equities, and given the poor performance of equities vis-a-vis bonds, this number must be under debate. Also given the beating many of these institutions have taken over the last year, they must be anyway in a mode to curtail their risk appetite. I am not sure these institutions were set up to be able to handle the type of volatility and synchronised drawdowns that we saw in 2008. Could we see a wave of rebalancing coming up from these strong hands? If we do, that is a real problem, for there are no other strong hands in prospect which could absorb these flows.
This poor performance also highlights the continued importance of dividends in establishing a reasonable return profile for equities. For the first time in 50 years, dividend yields had risen above bond yields (for a short period), potentially highlighting a behavioural shift where investors seek the safety of dividend payments over capital gains.
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All of the above obviously point to the risks we see if investors start questioning the long-held assumption of equity being the highest returning asset class. However, the horrendous performance of equities over the last two decades also may point to us coming to a really attractive long-term entry point for global equities vis-a-vis government bonds and cash.
G-secs globally look totally overpriced, and interest rates are at all-time lows. The world will not be in a deflationary bust environment forever. Yields and interest rates will have to normalise at some stage, as the world’s central banks cannot hold short-term interest rates at zero for extended periods. These assets are being bid up by a flight to safety, and on a relative basis equities have never been cheaper. Even on an absolute valuation basis, long-term measure like the Graham and Dodd PE and Tobin’s Q indicate that equities are cheap, much cheaper than they have been in the last two decades. All these valuation metrics have normalised and are at their long-term averages, but still need the markets to fall by another 15 per cent to reach typical bear market bottom type of valuations.
Equities have been a horrible place to be over the last two decades, and will inevitably put pressure on investors to forsake the “buy and hold” approach. However, just when investors begin to question the place and weightage of equities in their long-term asset allocation, we may be coming close to a really good long-term entry point for investors who wish to capture a serious upside over the coming decade (at the minimum, on a relative basis at least).